Equilibrium, Excess Demand, Excess Supply
A perfectly competitive market consists of buyers and sellers who are driven by their self-interested objectives. Recall from Chapters 2 and 4 that objectives of the consumers are to maximize their respective preference and that of the firms are to maximize their respective preference and that of the firms are to maximize their respective profits. Both the consumers’ and firms’ objectives are compatible in the equilibrium. An equilibrium is defined as a situation where the plans of all consumers and firms in the market match and the market clears. In equilibrium, the aggregate quantity that all firms wish to sell equals the quantity that all the consumer in the market wish to buy; in other words, market supply equals market demand. The price at which equilibrium is reached is called equilibrium price and the quantity bought and sold at this price is called equilibrium quantity. Therefore, (p*, q*) is an equilibrium if qD(p*) = qs p*)
If at a price, market supply is greater than market demand, we say that there is an excess supply I the market at that price and if market demand exceeds market supply at a price, it is said that excess demand exists in the market at that price.
Market Equilibrium: fixed Number of Firms
Equilibrium for a perfectly competitive market with a fixed number of firms. Here SS denotes the market supply curve and DD denotes the market demand curve for commodity. The market supply curve SS shows how much of the commodity, firms would wish to supply at different prices, and the demand curve DD tells us how much of the commodity, the consumers would be willing to purchase at different prices. Graphically, an equilibrium is a point where the market supply curve intersects the market demand curve because this is where the market demand equals market supply.
Shifts in Demand and Supply – In the above section, we studied market equilibrium under the assumption that tastes and preferences of the consumers, prices of the related commodities, incomes of the consumers, technology, size of the market, prices of the inputs used in production, etc. remain constant. However, with changes in one or more of these factors either the supply or the demand curve or both may shift, thereby affecting the equilibrium price and quantity.
Demand Shift – which we depict the impact of demand shift when the number of firms is fixed. Here, the initial equilibrium point is E where the market demand curve DD0 and the market supply curve SS0 intersect so that q0 and p0 are the equilibrium quantity and price respectively.
Now suppose the market demand curve shifts rightward to DD2 with supply curve remaining unchanged at SS0, as shown in panel (a). This shift indicates that at any price the quantity demanded is more than before. Therefore, at price p0 now there is excess demand in the market equal to q0q0”. In response to this excess demand some individuals will be willing to pay higher price and the price would tend to rise. The new equilibrium is attained at G where the equilibrium quantity q2 is greater that q0 and the equilibrium price p2 is greater than p0.
Supply shift – Now, suppose due to some reason, the market supply curve shifts leftward to SS2 with the demand curve remaining unchanged, as shown in panel (a). Because of the shift, at the prevailing price, p0, there will be excess demand equal to q0”q0 in the market. Some consumers who are unable to obtain the good will be willing to pay higher prices and the market price tends to increase. The new equilibrium is attained at point G where the supply curve SS2 intersects the demand curve DD0 such that q2 quantity will be bought and sold at price p2. Similarly, when supply curve shifts rightward, as shown in panel (b), at p0 there will be supply excess of goods equal to q0q0’. In response to this excess supply, some firms will reduce their price and the new equilibrium will be attained at F where the supply curve SS1 intersects the demand curve DD0 such that the new market price is p1 at which q1 quantity is bought and sold. Notice the directions of change in price and quantity are opposite whenever there is a shift in supply curve.
Simultaneous Shifts of Demand and Supply – What happens when both demand and supply curves shift simultaneously?
The simultaneous shifts can happen in four possible ways:
- Both supply and demand curves shift rightwards.
- Both supply and demand curves shift leftwards.
- Supply curve shifts leftward and demand curve shifts rightward.
- Supply curve shifts rightward and demand curve shifts leftward.
Market Equilibrium: Free Entry and Exit
In the last section, the market equilibrium was studied under the assumption that there is a fixed number of firms. In this section, we will study market equilibrium when firms can enter and exit the market freely. Here, for simplicity, we assume that all the firms in the market are identical. What is the implication of the entry and exit assumption? This assumption implies that in equilibrium no firm earns supernormal profit or incurs loss by remaining in production; in other words, the equilibrium price will be equal to the minimum average cost of the firms.
Shifts in Demand – let us examine the impact of shift in demand on equilibrium price and quantity when the firms can freely enter and exit the market. From the previous section, we know that free entry and exit of this firm would imply that under all circumstances equilibrium price will be equal to the minimum average cost of the existing firms. Under this condition, even if the market demand curve shifts in either direction, at the new equilibrium, the market will supply the desired quantity at the same price.
Applications – in this section, we try to understand how the supply-demand analysis can be applied. In particular, we look at two examples of government intervention in the form of price control. Often, it becomes necessary for the government to regulate the prices of certain goods and services when their prices are either too high or too low in comparison to the desired levels. We will analyze these issues within the framework of perfect competition to look at what impact these regulations have on the market for these goods.
Price Ceiling – it is not very uncommon to come across instances where government fixes a maximum allowable price for certain goods. The government-imposed upper limit on the price of a good or service is called price ceiling. Price ceiling is generally imposed on necessary items like wheat, rice, kerosene, sugar and it is fixed below the market-determined price since at the market-determined price some section of the population will not be able to afford these goods.
Price Floor – for certain goods and services, fall in price below a particular level is not desirable and hence the government sets floors or minimum prices for these goods and services. The government-imposed lower limit on the price that may be charged for a particular good or service is called price floor. Most well-known examples of imposition of price floor are agricultural price support programmes and the minimum wage legislation.
